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Bond Portfolio Strategies

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There are no permanent changes because change
itself is permanent. It behooves the industrialist to
research and the investor to be vigilant.


- Ralph L. Woods
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Outline
Introduction
Passive versus active management
strategies
Bond convexity
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Introduction
Fixed-income security management is
largely a matter of altering the level of risk
the portfolio faces:
Interest rate risk
Default risk
Reinvestment rate risk
Interest rate risk is measured by duration
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Passive Versus Active
Management Strategies
Passive strategies
Active strategies
Risk of barbells and ladders
Bullets versus barbells
Forecasting interest rates

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Passive Strategies
Buy and hold
Indexing

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Buy and Hold
Bonds have a maturity date at which their
investment merit ceases

A passive bond strategy still requires the
periodic replacement of bonds as they
mature
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Indexing
Indexing involves an attempt to replicate
the investment characteristics of a popular
measure of the bond market

Examples are:
Salomon Brothers Corporate Bond Index
Lehman Brothers Long Treasury Bond Index
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Indexing (contd)
The rationale for indexing is market
efficiency
Managers are unable to predict market
movements and that attempts to time the market
are fruitless

A portfolio should be compared to an index
of similar default and interest rate risk

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Active Strategies
Laddered portfolio
Barbell portfolio
Other active strategies
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Laddered Portfolio
In a laddered strategy, the fixed-income
dollars are distributed throughout the yield
curve
A laddered strategy eliminates the need to
estimate interest rate changes
For example, a $1 million portfolio invested
in bond maturities from 1 to 25 years (see
next slide)


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Laddered Portfolio (contd)
0
5000
10000
15000
20000
25000
30000
35000
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45000
50000
1 3 5 7 9 11 13 15 17 19 21 23 25
Years Until Maturity
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Barbell Portfolio
The barbell strategy differs from the
laddered strategy in that less amount is
invested in the middle maturities
For example, a $1 million portfolio invests
$70,000 par value in bonds with maturities
of 1 to 5 and 21 to 25 years, and $20,000
par value in bonds with maturities of 6 to 20
years (see next slide)


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Barbell Portfolio (contd)
0
5000
10000
15000
20000
25000
30000
35000
40000
45000
50000
1 3 5 7 9 11 13 15 17 19 21 23 25
Years Until Maturity
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$

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Barbell Portfolio (contd)
Managing a barbell portfolio is more complicated
than managing a laddered portfolio
Each year, the manager must replace two sets of
bonds:
The one-year bonds mature and the proceeds are used
to buy 25-year bonds
The 21-year bonds become 20-years bonds, and
$50,000 par value are sold and applied to the purchase
of $50,000 par value of 5-year bonds
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Other Active Strategies
Identify bonds that are likely to experience
a rating change in the near future
An increase in bond rating pushes the price up

A downgrade pushes the price down

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Risk of Barbells and Ladders
Interest rate risk
Reinvestment rate risk
Reconciling interest rate and reinvestment
rate risks
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Interest Rate Risk
Duration increases as maturity increases

The increase in duration is not linear
Malkiels theorem about the decreasing
importance of lengthening maturity
E.g., the difference in duration between 2- and
1-year bonds is greater than the difference in
duration between 25- and 24-year bonds
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Interest Rate Risk (contd)
Declining interest rates favor a laddered
strategy

Increasing interest rates favor a barbell
strategy
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Reinvestment Rate Risk
The barbell portfolio requires a reinvestment each
year of $70,000 par value
The laddered portfolio requires the reinvestment
each year of $40,000 par value

Declining interest rates favor the laddered strategy
Rising interest rates favor the barbell strategy
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Reconciling Interest Rate &
Reinvestment Rate Risks
The general risk comparison:

Rising Interest Rates Falling Interest Rates
Interest Rate Risk Barbell favored Laddered favored
Reinvestment Rate Risk Barbell favored Laddered favored
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Reconciling Interest Rate &
Reinvestment Rate Risks
The relationships between risk and strategy
are not always applicable:
It is possible to construct a barbell portfolio
with a longer duration than a laddered portfolio
E.g., include all zero-coupon bonds in the barbell
portfolio
When the yield curve is inverting, its shifts are
not parallel
A barbell strategy is safer than a laddered strategy
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Bullets Versus Barbells
A bullet strategy is one in which the bond
maturities cluster around one particular maturity
on the yield curve

It is possible to construct bullet and barbell
portfolios with the same durations but with
different interest rate risks
Duration only works when yield curve shifts are
parallel

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Bullets Versus
Barbells (contd)
A heuristic on the performance of bullets
and barbells:
A barbell strategy will outperform a bullet
strategy when the yield curve flattens

A bullet strategy will outperform a barbell
strategy when the yield curve steepens

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Swaps
Purpose
Substitution swap
Intermarket or yield spread swap
Bond-rating swap
Rate anticipation swap
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Purpose
In a bond swap, a portfolio manager
exchanges an existing bond or set of bonds
for a different issue
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Purpose (contd)
Bond swaps are intended to:
Increase current income
Increase yield to maturity
Improve the potential for price appreciation
with a decline in interest rates
Establish losses to offset capital gains or
taxable income
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Substitution Swap
In a substitution swap, the investor
exchanges one bond for another of similar
risk and maturity to increase the current
yield
E.g., selling an 8% coupon for par and buying
an 8% coupon for $980 increases the current
yield by 16 basis points

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Substitution Swap (contd)
Profitable substitution swaps are
inconsistent with market efficiency

Obvious opportunities for substitution
swaps are rare
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Intermarket or
Yield Spread Swap
The intermarket or yield spread swap
involves bonds that trade in different
markets
E.g., government versus corporate bonds

Small differences in different markets can
cause similar bonds to behave differently in
response to changing market conditions
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Intermarket or
Yield Spread Swap (contd)
In a flight to quality, investors become less
willing to hold risky bonds
As investors buy safe bonds and sell more risky
bonds, the spread between their yields widens
Flight to quality can be measured using the
confidence index
The ratio of the yield on AAA bonds to the
yield on BBB bonds
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Bond-Rating Swap
A bond-rating swap is really a form of
intermarket swap

If an investor anticipates a change in the
yield spread, he can swap bonds with
different ratings to produce a capital gain
with a minimal increase in risk
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Rate Anticipation Swap
In a rate anticipation swap, the investor
swaps bonds with different interest rate
risks in anticipation of interest rate changes
Interest rate decline: swap long-term premium
bonds for discount bonds

Interest rate increase: swap discount bonds for
premium bonds or long-term bonds for short-
term bonds
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Forecasting Interest Rates
Few professional managers are consistently
successful in predicting interest rate
changes

Managers who forecast interest rate changes
correctly can benefit
E.g., increase the duration of a bond portfolio is
a decrease in interest rates is expected
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Bond Convexity
The importance of convexity
Calculating convexity
General rules of convexity
Using convexity
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The Importance of Convexity
Convexity is the difference between the
actual price change in a bond and that
predicted by the duration statistic

In practice, the effects of convexity are
minor
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The Importance
of Convexity (contd)
The first derivative of price with respect to
yield is negative
Downward sloping curves
The second derivative of price with respect
to yield is positive
The decline in bond price as yield increases is
decelerating
The sharper the curve, the greater the convexity
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The Importance
of Convexity (contd)
Greater Convexity
Yield to Maturity
B
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P
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The Importance
of Convexity (contd)
As a bonds yield moves up or down, there
is a divergence from the actual price change
(curved line) and the duration-predicted
price change (tangent line)
The more pronounced the curve, the greater the
price difference

The greater the yield change, the more
important convexity becomes
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The Importance
of Convexity (contd)
Yield to Maturity
B
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P
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Error from using
duration only
Current bond
price
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Calculating Convexity
The percentage change in a bonds price
associated with a change in the bonds yield
to maturity:

2
2
2
1 1 Error
( )
2
where bond price
yield to maturity
dP dP d P
dR dR
P P dR P dR P
P
R
(
(
= + +
(
(


=
=
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Calculating Convexity (contd)
The second term contains the bond
convexity:

2
2
2
1
Convexity ( )
2
d P
dR
P dR
=
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Calculating Convexity (contd)
Modified duration is related to the
percentage change in the price of a bond for
a given change in the bonds yield to
maturity
The percentage change in the bond price is
equal to the negative of modified duration
multiplied by the change in yield
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Calculating Convexity (contd)
Modified duration is calculated as follows:
( )
Macaulay duration
Modified duration
1 Annual yield to maturity/ 2
=
+ (

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General Rules of Convexity
There are two general rules of convexity:
The higher the yield to maturity, the lower the
convexity, everything else being equal

The lower the coupon, the greater the
convexity, everything else being equal
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Using Convexity
Given a choice, portfolio managers should
seek higher convexity while meeting the
other constraints in their bond portfolios
They minimize the adverse effects of interest
rate volatility for a given portfolio duration
Riding Yield curve
An investment strategy in which one buys a
long-term bond and sells it before maturity.
Riding the yield curve allows the
bondholder to profit from the declining
yield that occurs over the life of the bond.

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Example
The purchase of a security with a longer term to maturity than the
investor's expected holding period in order to produce increased
returns by taking advantage of a positive yield curve.
For example, a $10,000, 26-week Treasury bill that yields 10%
annually will sell for $9,524, while a 13-week bill that yields 9% will
sell for $9,780.
Buying the longer-term security, holding it for 13 weeks, and selling it
at the existing 13-week bill price will produce a profit of $256, for an
annualized yield of (
$256
/
$9,524
) 4, or 10.75%.
This yield is considerably higher than what might be obtained by
simply purchasing a 13-week bill. Riding the yield curve increases
yield only when longer-term interest rates are higher than shorter-term
rates.

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